Incentives matter: this is the fundamental
concept in economics. People respond to incentives, so in order for us to predict people’s behavior,
we need to think about how their incentives have changed. For example when gas prices rise, people buy
less gasoline. They probably don’t stop buying gasoline, but they find ways to use
less. Maybe they combine their errands so they can take fewer trips. Prices are powerful
incentives. Government policy frequently relies on people’s response to incentives but often
fails to consider all the different ways it affects people’s incentives. For example there’s a strong desire in many
corners for people to use less gasoline. One way that government policy does this is by
CAFE standards. These are government mandates for car manufacturers to sell a fleet of vehicles
that have an average fuel efficiency at or above the standard, for example, 25 miles
per gallon. The idea is that if car manufacturers produce more fuel-efficient cars, consumers
will buy more fuel-efficient cars and use less gasoline. Sounds great, but this is where
economics comes in. As a consumer what happens to my incentive?
I buy a more fuel-efficient car. Well, now if before it took me 20 gallons of gasoline
to drive to visit my parents, now maybe it takes me 18. It lowers the cost of me driving
to visit my parents, so I’m going to drive to visit my parents more often. The change
in mandate reduces the cost of driving, inducing consumers to drive more miles. A good economist doesn’t just consider the
obvious effect of a policy: The change in mandate leads to more fuel-efficient cars.
A good economist also considers the less obvious effects: The change in mandate lowers the
cost of driving, inducing consumers to drive more miles with the attendant effects on pollution
and car emissions. Setting the right incentive and avoiding unintended consequences is difficult. Incentives matter is a relatively straightforward
concept. What’s difficult is to think about all the different ways the policymakers might
affect people’s incentives, and how that would change people’s behavior.